When you should use leverage in your trades?
When you should use leverage in your trades? I’m going to answer this question, but first, we have to mention two other questions to be answered.
Q1: What is a reasonable trade?
An order in which the entry point, stop loss, and take profit are already pre-defined based on a good return strategy or rules.
Q2: What is money management?
Money management is to determine the percentage of risk on the total balance in each order and to know what your position size will be and how much your potential loss will be.
We need to do some calculations to answer the first question.
Let’s suppose your account balance is $100 and the maximum risk on your balance for each trade is 5%. This means that on a reasonable trade, your loss will be $5 at most. Besides that, you have a good trading opportunity with an entry point at $10, stop loss at $9, and profit point at $12, i.e. 10% potential risk and 20% potential reward for the position.
Since we cannot lose more than $5 of our balance, we need a position size where the potential loss will not exceed $5. Which we can calculate with this formula: (Max risk on balance / position risk * 100). Which would be $50 [(5/10) * 100] in our case. [Figure 1, first from the left]
This means that we are only allowed to include $50 out of $100 in this trade; this would be $5 after a 10% loss.
Everything is normal and we can afford it, so we will do the trade.
Now, let’s increase the max risk on balance to 20%. It means our potential loss would be at most $20. By doing the same calculations considering the same reasonable trade with 10% risk, our position size will be $200 while we do not have more than $100, so where do we get $200 from?!
Yep! Leverage would help you in this case. So benevolent, isn’t it? [Figure 2, second from the left]
In this case, your leverage would be 2 and you can open a $200 position, but don’t forget you increased your account risk from 5% to 20% already.
Note that the risk will be applied to your real asset. If your balance is $100 and the leverage is 10, the exchange will give you about $1000 to buy or sell. While the 5% of $100 is $5, the 5% of $1000 would be $50, which is 50% of your real asset. So calculating the risk on leverage balance is practically meaningless!
What if we had 10 orders simultaneously? It means $100 will be split between 10 orders. For ease of calculation, we consider every 10 trades to be the same as what we had above, while each trade would have 10% of $100. In these conditions, each trade would again have a $50 position, but leverage will be 5! [Figure 3, third from the left]
Having said that, we can conclude that leverage alone is meaningless and finds meaning alongside reasonable trade opportunities and money management.
In the above explanations, for the ease of calculation and context understanding, I used rand but not necessarily correct values. For example, a risk ratio of 5% on balance is a really high risk or in the example of 10 trades at once, it is wrong to consider your balance as $100 at the start of each trade. In the worst-case scenario, you should deduct the loss of the previous trade from your balance for the next trade.
From the link below, you can access the tool I prepared to calculate the position details.
https://bit.ly/3PZrJz8
Feel free to give your constructive feedback.
Q1: What is a reasonable trade?
An order in which the entry point, stop loss, and take profit are already pre-defined based on a good return strategy or rules.
Q2: What is money management?
Money management is to determine the percentage of risk on the total balance in each order and to know what your position size will be and how much your potential loss will be.
We need to do some calculations to answer the first question.
Let’s suppose your account balance is $100 and the maximum risk on your balance for each trade is 5%. This means that on a reasonable trade, your loss will be $5 at most. Besides that, you have a good trading opportunity with an entry point at $10, stop loss at $9, and profit point at $12, i.e. 10% potential risk and 20% potential reward for the position.
Since we cannot lose more than $5 of our balance, we need a position size where the potential loss will not exceed $5. Which we can calculate with this formula: (Max risk on balance / position risk * 100). Which would be $50 [(5/10) * 100] in our case. [Figure 1, first from the left]
This means that we are only allowed to include $50 out of $100 in this trade; this would be $5 after a 10% loss.
Everything is normal and we can afford it, so we will do the trade.
Now, let’s increase the max risk on balance to 20%. It means our potential loss would be at most $20. By doing the same calculations considering the same reasonable trade with 10% risk, our position size will be $200 while we do not have more than $100, so where do we get $200 from?!
Yep! Leverage would help you in this case. So benevolent, isn’t it? [Figure 2, second from the left]
In this case, your leverage would be 2 and you can open a $200 position, but don’t forget you increased your account risk from 5% to 20% already.
Note that the risk will be applied to your real asset. If your balance is $100 and the leverage is 10, the exchange will give you about $1000 to buy or sell. While the 5% of $100 is $5, the 5% of $1000 would be $50, which is 50% of your real asset. So calculating the risk on leverage balance is practically meaningless!
What if we had 10 orders simultaneously? It means $100 will be split between 10 orders. For ease of calculation, we consider every 10 trades to be the same as what we had above, while each trade would have 10% of $100. In these conditions, each trade would again have a $50 position, but leverage will be 5! [Figure 3, third from the left]
Having said that, we can conclude that leverage alone is meaningless and finds meaning alongside reasonable trade opportunities and money management.
In the above explanations, for the ease of calculation and context understanding, I used rand but not necessarily correct values. For example, a risk ratio of 5% on balance is a really high risk or in the example of 10 trades at once, it is wrong to consider your balance as $100 at the start of each trade. In the worst-case scenario, you should deduct the loss of the previous trade from your balance for the next trade.
From the link below, you can access the tool I prepared to calculate the position details.
https://bit.ly/3PZrJz8
Feel free to give your constructive feedback.
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